What is Decentralized Finance (DeFi)?

The first and still the most famous cryptocurrency is bitcoin. You hear about bitcoin from every newspaper and you probably had to spend the last couple of years in a cave somewhere meditating with Buddhist monks to not know anything about it. Although who knows, maybe the monks are already mining a bit… Following bitcoin came the ether blockchain. It solved one serious problem – it greatly expanded the ability to create smart contracts, which in turn expanded the applications for cryptocurrencies. While bitcoin is mostly either used for speculation or for long-term investments (HODL!), the ether blockchain, thanks to smart contracts, has grown an entire ecosystem of financial services, which today we call decentralized finance (DeFi).

Nevertheless, the experimentation did not stop with ether. Ether has a significant disadvantage at the moment – the bandwidth of this blockchain is only a few dozen transactions per second. Due to the very high popularity of DeFi and NFT, the network is constantly overloaded and this leads to very high transaction costs. Any simplest transaction on ether costs hundreds of dollars.

New blockchains appeared as an answer to this problem – Solana, Tera and Avax are the most popular of the alternative blockchains, they can support from several thousands to tens of thousands of transactions per second, thus reducing transaction costs by about 1,000 times. On the Terra blockchain, for example, small transactions cost a few cents.

This rapid growth of ether and alternative blockchains has caused bitcoin’s share of total cryptocurrency capitalization to drop from 90% in 2017 to around 40% today.

An ecosystem of financial applications and services (they are called dApps / decentralized applications) based on smart contracts on the ether blockchain and other alternative blockchains is decentralized finance (DeFi).

The total capitalization of investments in various DeFi applications and services is currently about $230 billion and has grown about 10 times in the last year.

Popular DeFi Applications

I’m going to talk about DeFi using several applications that exist on the Terra blockchain, which is the second most capitalized DeFi blockchain after ether. First, my personal experience is mostly limited to the Terra blockchain and I want to talk about what I do and understand myself, rather than engage in theoretical reasoning about how it works. Secondly, due to the high commissions on ether, most readers won’t be able to try to use these applications anyway, hardly many will want to throw away a couple hundred dollars just to experiment with DeFi. On the Terra blockchain, on the other hand, the commissions are very low and anyone can practically try what I’m about to talk about.

Let me say right off the bat, what I’m talking about below is one very small fraction of the entire DeFi market.

Steaking

Without going into technical details, steaking is similar to owning blockchain shares. For example, this is how it works on the Terra blockchain: You buy a LUNA token, give it to a so-called validator, and get a portion of the commissions paid by blockchain users. This is the first source of income; second, you can make or lose with the change in the value of this token. You get some commissions for transactions on the blockchain because with your deposit you help the validator perform the same function that miners do for bitcoin, i.e. they confirm transactions and keep the whole blockchain functioning. Currently, LUNA’s staking yield is 7% per annum. This is one of the most conservative forms of returns in DeFi because no matter what happens to prices, as long as someone is using the blockchain, you will earn a return on their fees.

Of course, that leaves the volatility of the token itself. The economics of this blockchain (tokenomics) are arranged so that the more different applications are used on the blockchain, the more expensive the LUNA token is.

In addition to the “dividend” yield from stacking, you get a say in all matters concerning the management of the blockchain, which you delegate to your validator. In other words, validators vote on different propositions and the weight of their vote depends on how much capital the investors have entrusted to them. This is similar to how voters vote for parliamentary parties and parties in turn vote for individual laws. The difference is that you can change your vote at any time and go to another validator whose decisions you are more in agreement with.

In general, it is like a stock company that distributes dividends to its investors in the form of staking returns, and is in a state of constant shareholder meeting – voting on this or that proposal takes place online at any time.

Here I would like to mention one important concept, tokens do not have to be “currencies” at all, acting as a means of payment. Token is a universal instrument, which can be something like stocks (as described above), bonds, currency, artwork or status symbol (NFT), and many other functions. It is a universal concept whose application is not limited to a means of payment.

Deposit in Anchor

Anchor protocol can be called a crypto-bank. It allows you to borrow against cryptocurrencies and accepts deposits at interest. The token in which deposits and loans are accepted is the UST Stablecoin, which is equal to one dollar. The idea is that if you want to borrow $100, you need to provide collateral in cryptocurrency, at least $200. The protocol has two sources of yield: first is the interest on the loan paid by the debtors, and second is the staking yield of this cryptocurrency as Anchor uses tokens received as collateral for staking, as described above

Example: someone borrows $100 and provides a $200 LUNA token as collateral. First, he pays interest on the loan, about 15% per annum, and second, the $200 pledge yields a 7% return.

On the other hand, deposits pay 19.5% APR at this point.

Criticisms and risks:

• this protocol has been attracting significantly more deposits than it has been making loans lately, accordingly the high yield is likely to decline very soon, or they will limit their deposit intake;
• at the moment, Anchor is trying to attract new borrowers by offering them cashback, a portion of the interest paid on the loan in the form of their own ANC token, this can be compared to.

• there is a risk that the smart contract of this protocol will be hacked and your entire deposit will be lost forever, such hacks at DeFi happen quite regularly

• There is a risk that the UST token will stop being worth $1, this has happened in the past during the general collapse of cryptocurrencies, it went down to about $0.85 last May.

The point is that it is an algorithmic stablcoin that is not backed by real dollars. Its parity with the dollar is maintained in a different way, more on that here. The concept of algorithmic stabcoin itself is an experiment whose success is not guaranteed.

Pros:

• The smart contracts of this protocol have been audited three times by a third-party audit that confirmed no vulnerabilities, no hacks have occurred so far;
• it is possible to buy smart-contract insurance, it means that if the protocol suffered a hacker attack and you lose your money another insurance protocol will reimburse them to you, the cost of such insurance is 2% per year at the moment;
• even if the return on deposits falls by half, it will still give a fairly high return. It is clear that today’s high yield is not forever;

The most important plus in my opinion is the business model of crediting against collateral of cryptocurrency: it is like a loan against securities at brokerage with the difference that market of cryptocurrencies is open 24/7, i.e. in case your collateral will fall below the minimum collateral level the collateral will be automatically sold at market with small discount and credit will be closed from this money.

Astroport Decentralized Exchange (DEX)

This application is a decentralized exchange, i.e. the place where you can sell and buy different tokens. The main difference with traditional exchanges is that the liquidity needed to create a market is provided by any private investor, who will earn a portion of the commissions received by the exchange for transactions.

Providing liquidity works like this: you provide $100 in UST token and $100 in LUNA token to the liquidity pool. These tokens will be used by the algorithms of the automatic market maker to create liquidity on the decentralized exchange. As remuneration, you receive commissions paid by exchange users plus additional remuneration in the tokens of the exchange itself. For example, for the UST/LUNA pool, the total return at the moment is about 30% per annum. This yield can be very different for different tokens.

There is an opportunity to get even higher yields here, but the level of risk is also higher than in previous protocols. In practical terms, this translates into the fact that if one of the tokens for which you provide liquidity changes significantly in price relative to another token, you will incur a loss compared to if you had not participated in the liquidity pool.

The high return on participation in the liquidity pool is designed to, among other things, compensate for possible impermanent loss. Accordingly, the more volatile a pair of tokens is, the higher the reward in the pool will usually be.

Traditional applications

From everything described above, you may have noticed that DeFi looks like such a closed system, where everything is based on constant active speculation in cryptocurrencies. Speculators make a lot of transactions, the commissions for which are the income of the stackers as well as those who participate in the liquidity pools. Speculators borrow against cryptocurrencies, thus creating demand for cryptocurrency deposits. Where is the connection to the real world outside the Internet?

Today, the first serious uses of DeFi outside of financial speculation are already beginning to emerge.

Meet the CHAI payment card: payments made with this card or via a virtual card are conducted via Terra’s blockchain. What does this mean in practice? In practice, it means that using this card with merchants who are also connected to Terra’s blockchain, payments are cheaper and faster than using other traditional payment processing methods. This card is popular in South Korea, where they have managed to integrate with a number of popular online and offline merchants.

Merchants are motivated to integrate with Terra’s blockchain because it offers significantly lower payment processing costs as well as a final payment in 6 seconds, significantly faster than other traditional payment processors in South Korea.

For example, cab drivers in South Korea are more than happy to accept CHAI cards because they allow you to get money into your account in a matter of seconds, unlike other cards that require you to wait several days to pay. Make a trip, get money in your account in seconds – go buy gas or withdraw money from an ATM.

The way this works is that on Terra’s blockchain there is a steblecoin KRT whose value is tied to one South Korean won, when a user makes a payment for bread and milk at a store connected to the blockchain this transaction happens directly on the blockchain, cheaper and faster than their competitors. Because of these attractive conditions for the merchant, they offer cashback and discounts to customers who use this card. Today, more than 5% of South Korea’s population uses the CHAI card.

Many of the users of this card don’t even know they are using blockchain. They’re not interested – they use the card because it’s convenient for them.

How does all this relate to what we discussed above about DeFi investment opportunities? The commissions paid by millions of card users, CHAI in South Korea is the revenue of the LUNA token stackers. Remember the 7% revenue I mentioned above? Well, part of that revenue is a fee for the use of the Terra blockchain by South Koreans, which you can receive as a “shareholder” of that blockchain.

I think this is a very interesting example of how DeFi is starting to penetrate the “real world” and traditional finance: CHAI recently announced an expansion into Thailand and Indonesia and a similar blockchain-linked card appeared in America.

Who needs decentralization?

Okay, above we briefly discussed some real-world applications of DeFi, and the connection between DeFi and traditional finance. I’d like to end with a few reasons why I think many people might be interested in DeFi:

1. Self-Custody. This is both one of the pros and one of the cons of DeFi. On the one hand no one can block your account, no one can stop the payment, and no one will ask for documents or other explanations for the transaction on the blockchain. You can transfer your funds to whomever you want, whenever you want, and as much as you want. You don’t have to ask anyone for permission to make your payment. Your funds in the blockchain are really 100% your funds. On the other hand, the lack of regulation means that you can fall victim to fraudsters or hackers and lose your funds, with no way to get outside help. There is no call center of any kind where you can call to complain, if your tokens are stolen they are gone forever.

2. Low cost. Terra blockchain, but it’s not the only one, allows you to make almost instant payments from anywhere in the world to anywhere in the world for a very low fee. What’s more, applications like Anchor can manage tens of billions of dollars with minimal cost – almost all processes are automated through smart contracts.
3. Global services and capital market. Unlike traditional financial industry, there are no geographical restrictions in DeFi. You can start interacting with a financial service created in Korea or Canada without any limits. If someone in Vietnam has an interesting idea that will be realized, they can immediately begin to attract customers from all over the world.
4. Composability. Most blockchain-based financial applications are open-source projects, which means that each new application can easily integrate with existing applications if desired, so there are more and more complex products that teams around the world are working on. This can be compared to the financial LEGO.

In addition, more and more “bridges” between different blockchains are emerging today, creating one global blockchain ecosystem out of the many disparate individual ecosystems that existed only recently.

Overall, it must be reiterated that the entire DeFi industry, despite significant growth over the past year and a half, remains a great experiment. Each of DeFi’s practical applications carries very high risks. The high returns available in DeFi are by no means risk-free, even if you use tokens whose value is tied to traditional currencies (stabelcoins). I personally will be very interested to see what this industry will look like in 2-3 years. Given the very high rate of innovation and the complete absence of regulatory barriers, you can expect significant changes in that time.